Return on Capital
What it is:
How it works (Example):
For example, Manufacturing Company MM has $100,000 in net income, $500,000 in total debt and $100,000 in shareholder equity. Its operations are simple -- MM makes and sells widgets.
We can calculate MM's return on capital using the above equation:
(Net income - Dividends) / (Debt + Equity) = (100,000 - 0) / (500,000 + 100,000) = 16.7%
Note that for some companies, net income may not be the best profitability measure to use. You want to make sure that the profit metric you put in the numerator provides a genuine measure of profitability.
Return on capital is most useful when you're using it to calculate the returns generated exclusively by the business operation itself, not the short-lived results from one-time events. Gains/losses from foreign currency fluctuations and other one-time events contribute to the net income listed on the bottom line, but they're not results from business operations. Try to think of what your business "does" and only consider income related to those core business operations.
For example, Conglomerate CC lists $100,000 as net income, $500,000 in total debt and $100,000 in shareholder equity. But when you look at CC's income statement, you notice a lot of extra line-items, like "gains from foreign currency transactions" and "gains from one-time transactions."
In the case of CC, if you use the net income number, you are not being very specific as to where the returns are being generated. Were they from strong business results? Were they from fluctuations in the foreign currency markets? Did CC sell a subsidiary?
For CC, it makes more sense to use an income measure called net operating profits after tax (NOPAT) as the numerator. It's not found on the income statement, but you can calculate it yourself using the following equation:
NOPAT = Earnings before Interest & Taxes * (1 - Tax Rate)
Using NOPAT in the equation will tell you the return the company generated with its core business operations for both its bondholders and stockholders.
Why it Matters:
A firm's return on capital can be an excellent indicator of the size and strength of its moat. If a company is able to generate returns of 15-20% year after year, it has a great system for transforming investor capital into profits.
Return on capital is especially useful for companies that invest a large amount of capital, like oil and gas firms, computer hardware companies, and even big box stores. As an investor, it's imperative to know that if a company uses your money, you'll get a respectable return on your investment.